The Startup Dilemma
Every time we head to San Francisco, we can’t help but think about the start-up scene. Where as Los Angeles is dominated by the entertainment industry and New York by finance, outside of the ever-present homeless population, the Bay Area oozes tech startup. It has an almost hive like energy. Whereas the world of finance or entertainment can often feel like ants marching to the same beat, creating an almost overwhelming force to be reckoned with or more often a tidal wave to be avoided. That controlled frenzy is missing in the Bay Area. There is nothing controlled. It feels like a constant rave, but not too dissimilar from the Los Angeles entertainment business, it experiences trends and frothiness as companies look to back the next big thing. It’s why we can see so many movies with similar story lines coming out at once. They may try to keep things closely guarded, but it doesn’t take much for the buzz to spread and influence what others make.
In more ways than we have originally thought, making movies and backing companies look more alike than we would have expected. It’s almost always about the blockbuster. In the grand scheme, they represent a rather small percentage of the movies made, but the lion’s share of the revenues come from the big bets. Rarely are these the most profitable films. Those come from unexpected hits, My Big Fat Greek Wedding, made for a few million but grossed more than two hundred million in North America alone. Ghost. Home Alone. Some of the most beloved movies are the most profitable. And, if they don’t do as well, the companies who produced them have less at stake. They also take less time to produce, so they could make more movies per year than if they were to focus solely on the blockbusters. But, that’s not quite how the movies or life seem to work. We’re hits driven. The homerun hitter makes more than the player with the best batting percentage. And, as that is true of Hollywood, it is also true of the Hollywood of tech investing, Silicon Valley.
The math behind Silicon Valley goes something like this. A fund has x amount of money they get to invest. Let’s say that number is big but not obscene, $500 million. The fund overall has a return that it wants to achieve for those who put in the $500 million. Let’s call that $2 billion in five years, a 4x return over a relatively short time frame. If they invest $1 million into a company, and that company does well by most people’s standards, selling for four times the amount the investors came in at, that’s good, but it creates a problem. For the fund to get 4x its investment, it would need to bat 1000 if its companies “only” made it four times on its money. Take the Google scenario for example, or more recently the Facebook one. A company puts in $20 million, which on a $500 million fund is less than 5%. The company explodes, becoming a “breakout,” worth at the time of exit $10 billion, where as it was worth $100 million at the time of investing. That’s 100x on the money. All of a sudden that $20 million is now worth $2 billion, producing enough of a return to almost cover the entire target of the initial fund. These breakout companies though don’t just return 100x.
With a company like Facebook, the early investors are already sitting on 1000x gains ($50 million value to $50 billion), meaning even an angel investment of $25,000 will yield $250 million. Who wouldn’t have liked the chance to put in $25,000 then. Any of these investors could happily sell some of their stake to later investors (as it is not public yet and still make outrageous returns). That angel could sell half their stake and make $100million. With all the other rounds, it isn’t generally quite that rich, so instead of 1000x, we’re probably talking 250. That still makes $25,000 worth more than $60 million and $20 million worth $500 million. With those odds and the need to make a “modest” 4x on the initial $500 million fund, you start to see why venture firms swing for the fences. Like baseball, it’s America’s banking as the terminology from baseball is constantly interwoven into the strategies for investing.
That’s why it is tough being a utility player, a company that does good and is a solid business, just not a breakout business. It’s why we find all sorts of specialty funds, e.g., those who invest only $25,000 but they do so at the earliest stages that it still comes across as both a big gamble and a means to touch hundreds of businesses. What we don’t seem to find, though, are those who want to produce My Big Fat Greek Wedding, a likely solid movie but unlikely hit. There seems to be a vacuum for those who want to operate in proven, money making industries but whose firms are unlikely to become the breakout. Why invest in an education lead generation startup (even in the heyday) when the whole industry only earns in the low single digit billions, when you could invest in something that just maybe could do a billion in revenue on its own.
A friend of mine who invests jokes that it’s harder for companies that make money than those that don’t to get a good valuation. A proven business is sometimes the hardest thing. Yet, take the mobile phenomenon, Colour, who managed to raise $40 million before they had an app in any app store. On that investment, a friend quipped that you would have to be the worst entrepreneur in the world to have $40 million and not create a business that earns $100 million per year. They could buy 800 McDonalds or build an entire skyscraper and rent it out to make the money. It’s almost impossible not to do well with so much cash. Of course, they didn’t get that money to open a franchise, but it couldn’t illustrate better the desire to back the next big thing. We just hope that others will step up and back the next pretty good thing. Otherwise, we are left with two extremes – businesses that make money without a desire to try and create long-term value and a small handful of blockbusters who wouldn’t have been possible were it not for hundreds of millions of dollars in capital. Then again, extremes are what we seem to like.
